Being a collection of thoughts, observations, comments, opinions and views on investing--especially for the long term.
Disclaimer: This blog is not intended as professional advice. Please seek your own professional advisor who can properly review your particular circumstances. The author disclaims any liability, loss, or risk taken by individuals who directly or indirectly act on the information contained herein. All readers must accept full responsibility for their use of this material.

Friday, September 28, 2007

Which should I use, a full-service or discount broker?

Reader's Question: I trade commodities through a full-service broker, paying commissions of $73 for each option trade I make. I am considering switching to a discount broker for lower commissions but have read that discount stock brokers can end up costing an investor more through "hidden costs" coming from time delays in trade execution, worse pricing when filling orders, etc. Which is the better alternative: full-service or discount?

Trading Cost Comparison

First, from a trading efficiency point of view, we need to examine whether the higher commissions full-service brokers charge are worth any improved trade execution they offer. For the sake of this discussion, I assume that considerations relating to the choice between full-service or discount brokers generally apply to both commodities and stock trading. The information I share comes from the stock arena.

In the way of background, you may wish to browse an SEC article summarizing the methods available to a broker for execution of a customer's trade: a) direct to stock exchange; b) through a market maker, with the broker earning payment for order flow; c) to an electronic communications network (ECN) for automatic processing, particularly for limit orders; and d) internalization of the trade on the brokerage firm's own account. Discount brokers often route trades through third-party market makers and get paid a "rebate" for order flow, which allows them to offer lower commissions. Full-service brokers usually route trades more directly to the stock exchange, which can result in better execution. Let's see how the two compare.

An academic paper published in 2005 reports on an empirical study conducted in 1999 involving 64 actual (32 buy and 32 sell) trade executions of 100 shares each of NYSE- and Nasdaq-listed stocks through six different brokerages, two from each of three categories: full-service voice-order brokers charging commissions averaging $47, brand-name online brokers with $23 average commissions, and deep-discount online brokers with $7.50 commissions. The authors found that "for NYSE listed stocks online brokers disproportionately route orders to regional and third-party exchanges offering fewer price improvements, compared to traditional brokers." However, for trading involving a 50/50 mix of NYSE- and Nasdaq-listed stocks, "we find no statistically significant difference among the three types of brokers on price improvements." Consequently, "Our empirical study found that online brokers offer lower quality trade execution [by about $0.01-$0.02 per share on NYSE trades], but that the higher commission costs of full-service brokers are not [emphasis mine] offset by these quality differences."

The bottom line is that you can generally execute "retail" size, small trades more efficiently using online discount brokers, since what you save through lower commissions will typically more than offset what you lose through the marginally worse trade execution the discount brokers tend to provide. However, if a full-service broker has a more direct connection to the commodities or stock exchange and can achieve better fills by, say, a penny or two on an underlying price of $50 to $100--that's one part in 5,000--then when notional trade size exceeds about $250,000, we reach a breakeven between paying commissions of $20 to a discount broker or $70 to a full-service broker.

Suggestion: You can do your own "experiment" by opening up accounts at both a full-service and a discount broker, splitting your trades in half, and proceeding to give equally sized, simultaneous and identical orders to both brokers. This will allow you to check which alternative really offers you more efficient overall trade execution, taking both commissions and fill pricing into account. If you do proceed with the experiment, I and many other readers I'm sure would be curious to find out what you discover; so, please post your findings as a blog comment below.

What's a Broker Relationship Worth to You?

Beyond strict, easily measurable economic cost, another consideration is that, if you have developed a good relationship with a full-service broker and believe you are significantly benefiting from the trading and investment advice and market information the broker provides, then you might not want to switch.

Here's some anecdotal evidence that may help: A few years ago a friend of mine told me that, despite drastically reduced commissions available through Internet-based discount brokers, he sticks with his traditional full-service broker since he "enjoys" being awaken at five in the morning by phone calls from his broker with breaking news about the stocks he owns. He insists that on at least a few occasions timely information from his broker directly impacted his buy-sell decisions and actually allowed him to make "many thousands of dollars" in profit, far outweighing the "mere hundreds of dollars" he paid in full-service commissions each time he traded.

Personally, I'm at the other end of the spectrum. I like to rely on my own ability to follow and interpret the news and do my own analysis. As such, I favor using reputable online discount brokers (at commissions of about $10 per trade) and can live very happily without any word-of-mouth investment tips, information and advice from brokers. At the same time, however, I do realize that there are some successful and sophisticated investors who prefer the full-service alternative, if for no other reason than they choose not to spend their time watching the markets so closely. Perhaps it's more of a lifestyle choice than anything else.

6 Comments:

Anonymous said...

I have been using PTI Securities & Futures LP (ptisecurities.com) as my broker for the past 4 years and I love this firm! I am not 100% confident enough to use, say, PTI ProDirect (ptiprodirect.com) to trade independently, which is why when I have a question the PTI Securities brokers (who are very down to earth) are great to talk to - worth every penny to me. Thanks!

there are many brokers out there who will guide you via a good online trading platform to match one's style. Above all, they will still assist you with order placement. Technical support and the ability to phone in orders is most important. Always have a live broker behind the platform.

Does a brokerage firm owes its investor clients an ongoing duty to monitor the investments held in the customer’s accounts to ensure that the investments remain suitable and appropriate for the customer’s needs and circumstances?